Multiple financial experts have unanimously agreed with economists that financial education is compulsory for economic growth and eventually leads to financial inclusion. All of them unanimously agree that financial literacy is path forwards for economic growth, job generation, wealth generation, and asset creation within the nation.
Equal and equitable distribution of wealth provides much higher economic growth, increases financial participation, and reduces corruption. Reduced corruption eventually leads to the proper functioning of democratic and judicial institutions, the establishment of a free press, and the overall maintenance of human rights. Democratic prevalence in society automatically ensures equal distribution of wealth, and the cycle continues.
Among the OECD or the Organisation for economic co-operation and Development nations, financial inclusion and equitable wealth distribution were prioritized after the world war. In the aftermath of World War II, the besieged nations put their heads together. They put an economic framework for building infrastructure, giving access to the necessities like education, transportation, health care, and communications.
These steps improved consumer confidence which in turn produced massive consumer spending. Consumers boosted productivity and eventually created well-paying jobs. All the governments of the developing nations have started to look toward financial growth and boost their economy. Around 59 countries have agreed to provide a framework to induce financial inclusion into their economic systems.
Behavioral Science | Concerning Finance
Worldwide psychologists, psychiatrists, social scientists, and sociologists have researched that traditional economic policies and marketing tactics do not work with most human beings. They have concluded that human beings are not entirely rational beings and not logically-minded concerning areas of finance. Because of this, most people have never managed to finance their whole and have been inefficient in saving.
The field of behavioral economics has been resurging since the 1970s. Since then, there have been multiple debates and discussions about the tendencies of economic behavior and trying to identify specific patterns. But as of now, the pattern has been ungraspable, and there haven’t been any breakthroughs to identify the irrationality in their behaviors. There have been better techniques to determine the trends and predict the behaviors of stock markets but not humans.
Human beings can also be considered a stock market. It has mood swings and peaks, which are low and sometimes difficult to predict. Like the stock market, you cannot predict what impact different external circumstances will have. However, there is a difference between humans and stock markets. Humans have far more complex emotions than inanimate stocks and react in far more complex ways than a stock market. But does understanding financial conditions and trends offer a better, if not resolute, solution to our behavioral enigma? Also, does understanding behavioral finance a key to the global challenge to achieve financial inclusion by 2020? Let’s discuss this.
Scientists and psychologists experimenting and researching behavioral finance have argued against traditional finance theory. Behavioral finance is a subbranch of behavioral economics that lays the foundational idea that humans, with their complex emotional and cognitive structure, tend to make irrational decisions when it comes to financial decisions like savings, spending, investing, and so on.
This branch of psychology is so exciting and beneficial that even investors have started looking into behavioral finance and determining consumer behavioral patterns and biases and how it affects stock prices. The idea of psychology that human behavior is irrational and unpredictable is the antithesis of the idea that the economic system is efficient and be put into identifiable patterns of prediction. This strict idea that the markets are efficient enough to weather the storms of uncertainty is called the efficient market hypothesis.
Efficient Market Hypothesis
The Efficient Market Hypothesis entails that the market system is perfect and efficient and works under the specific principles, rules, laws, and patterns which can be determined, predicted, and calculated in terms of certainty. Many investors and financial experts believe these laws and patterns can be exploited to gain an edge over the market, which in the world of investing and the stock market is called the “alpha” generation in investing terms.
According to the efficient market hypothesis, the stock prices listed are correctly valued, making it easier for investors to buy affordable stocks and sell those inflated stocks, making it impossible for anyone to outwit the market. However, some people can use these patterns to edge over competitors.
Many behavioral scientists have concluded that it is impossible to determine market trends based on human behavior and pointless to try through either fundamental or technical analysis. The efficient market hypothesis has become the cornerstone of behavioral science, which has an air of certainty on these issues.
Still, there has been significant criticism and backlash to this hypothesis. While academic research has issued numerous pieces of proof in support of his theory, an equal number of dissenting voices also exist with hardcore evidence. Supporters of this theory often comment on the Mor committee report. At the same time, the detractors often cite the example of the 1987 stock market crash when the Dow Jones Industrial Average Index fell by 20% in a day, and the stock bubble burst as the manipulated stocks crashed.
The Importance of Losses Versus Significance of Gains
The late 20th century to the mid of the early 2000s has seen its fair share of stock market crashes and economic downturns. The dotcom crash of 1997 to the 2008 Lehman Brothers recession, which crashed the whole real estate market, as well as the great depression of the pandemic, are some of the most famous examples. These examples allow the researchers to gauge the problem and discover that irrational behavior isn’t a rarity but normal and prevalent.
Here’s one example which can help you understand. Imagine a situation where you offer a person two choices–the first choice of having $50 cash and the second choice of having $100 at the flip of a coin or nothing. Rationality dictates that most people will go for the first choice of certainty. Now offer a different situation where there’s a choice between a) an inevitable loss of $50 and b) $100 at the flip of a coin or nothing.
Rationality will tell you that people will choose the first option where the loss is minimal, but according to the survey, most people will choose the second option. People tend to control their losses instead of attempting to take risks for gain. This is called loss aversion.
The incident at Nortel Networks, a private equity firm, accentuated this experiment. When the 2008 financial crisis hit the market hit, their stock prices plummeted from over a hundred dollars to a meagrely two dollars a share. But investors kept holding on to the stocks hoping their prices would surge rather than take the loss head-on.
Behavioral Economics and Financial Inclusion
To understand behavioral economics, we must follow the principles of normative economics. Normative economics is the regular or idealized perspective toward economic development, investment, and banking. Normative economics tells what specific conditions should be or ought to be. Normative economics provides judgments and solutions to the economic solutions instead of programs.
Behavioral economics is the complete opposite of this ideology. Behavioral economics pertains to the idea that humans have irrational behavior, and their behavioral patterns cannot be predicted. These unpredictable behavior patterns drive consumption patterns, which affect the economy.
In the ideal world, people are expected to make rational, logical decisions based on the circumstances. In this case, the rational decision means maximizing profit and minimizing losses and risk. But that, more often than not, doesn’t happen. Behavioral economists and psychologists proclaim that humans grow up in the far complex societal system which affects their behavior.
Behavioral economics transcends the limitation of traditional economics. Behavioral economics studies how humans behave and how that affects consumption patterns. According to Dr. Carolyn McClanahan, the founder, and director of Financial Planning at Life Planning Partners Inc., people’s consumption depends on the environment they grow, affecting their physical and mental health, going into a spiral.
When financial health is weakened, the constant stress releases chemicals called catecholamines, which affect a person’s thinking. It has been proven that understanding consumer behavior that makes benchmarking progress toward financial inclusion.
Moreover, the relationship between stress and financial health is seen in China’s credit market. The rural population faces tremendous stress when they cannot repay their loans, taking more loans to pay back. This decreases their credit score. But new credit scores might help bridge China’s credit gap.
In the private industrial sector, behavioral economies have been used to predict patterns in product consumption and customize the product according to the needs of the people. Traditional economics dictates that the customers will look for all the features and weigh all the salient facilities for a product and service that appeal to them.
But behavioral economic dictates that are not the case. Humans generally are inclined toward the brand which appeals to their emotions. Recent research conducted in the democratic republic of Congo reveals that convenient payment enables more consumer spending tapping into the potential of the unbanked in DRC.
Q1. What do you mean by behavioral finance?
Behavioral finance is the study of the consumption patterns of humankind. Human emotions are complex, and many factors are incorporated into their decision-making. Also, humans form complex relations and communications, making their consumption unpredictable.
Q2. What are the last four simple ways to apply behavioral insights?
The four ways to gauge behavioral insight are
- Make tangible benefits
- Make action easier
- Gauge the bias
- Provide multiple references
Q3. What is an example of behavioral insights?
One of the best ways to implement behavioral insights has been seen in the united kingdom tax council. Behavioral insights have been used to make payment of taxes easier.
Behavioral science has been an exciting field for economists, investors, bankers, and entrepreneurs to measure the consumption patterns of humans, which affect the overall economy and macro-industry. Behavioral financing or economics is the antithesis of the traditional economic theory, also called the Efficient Market Hypothesis. The efficient market hypothesis believes the free market is efficient and perfect and follows specific laws and patterns which can be predicted. However, there are enough dissenters to discredit this theory.
- Jonas Taylor is a financial expert and experienced writer with a focus on finance news, accounting software, and related topics. He has a talent for explaining complex financial concepts in an accessible way and has published high-quality content in various publications. He is dedicated to delivering valuable information to readers, staying up-to-date with financial news and trends, and sharing his expertise with others.